It may be "The Cheesiest" but I can't bring myself to buy it
A couple of months ago the huge food company Kraft (KFT) popped up on my radar as a stock that I might want to consider purchasing. The thing that initially piqued my interest in the company, besides the fact that it's cheap (14 times trailing earnings) and it pays a solid dividend (currently 3.9%) was a fantastic presentation that the famous hedge fund manager Bill Ackman put together on it (link).
Ackman's fund Pershing Square Capital Management has a large position in the company and he makes a compelling argument about why it is currently an attractive investment. Ackman believes that Kraft's recent, well-publicized acquisition of the candy company Cadbury significantly improves Kraft's business quality and organic growth profile by providing it greater access to emerging markets and new products, ultimately leading to the margin expansion that the combined company desperately needs.
Kraft’s EBIT margins plummeted from a high of 21% in 2002 to a recent low of 12.8% when commodity prices spiked in 2008. They currently sit at around 13.6%. To put in perspective just how bad Kraft's profit margins are, compare that number to a 17.7% margin at General Mills (GIS), 17.7% at Smuckers (SJM), 17.5% at Campbell Soup (CPB), and 16.4% at Kellogg (K). Basically, Kraft has the worst margins in the biz.
Ackman believes as a result of a series of cost cutting initiatives and R&D on new products that Kraft will be able to improve its margins to around 15% by 2011. His presentation goes into the margin issue in much greater depth and he makes a very compelling case that KFT will be able to improve its margins and in turn boost its stock price down the road.
I was close to pulling the trigger and investing in Kraft, but a few things kept on bothering me.
First, not only do I believe that Kraft overpaid for Cadbury, but it added insult to injury by using its own undervalued stock to pay for a huge chunk of the transaction. It also even sold its recently very successful Frozen Pizza business that it should have held onto to help fund the deal.
Making matters even worse, Kraft management completely dropped the ball by failing to notice that it does not have the authority to alter the generous pension plan that Cadbury has in place for more than 3,600 employees (link). Now the company is scrambling to try to fix the problem and creating lots of ill will.
Furthermore, I have absolutely no faith in Kraft management's ability to improve margins. Kraft started a big restructuring program to help it operate more efficiently all the way back in 2004 and it has seen little improvement yet.
Kraft's CEO Irene Rosenfeld has been in place since mid-2006 yet the company's margins are worse today than they were back then and its stock has gone absolutely nowhere.
The straw that broke the camel's back for me was when Rosenfeld decided to give herself a raise from $18.7 million in total compensation in 2008 to $26.3 million in 2009 (it's nice to be both CEO and chairman of the board isn't it?). Ahhhhh, for what?!?! For throwing so much money at Cadbury that they couldn't say no to a deal. Anyone can throw money around, it takes real skill to successfully integrate such a huge acquisition. I would have had no problem if Rosenfeld paid herself zillions if she is able to smoothly incorporate Cadbury into Kraft and to improve the company's industry-worst margins over the next year or two, but she's done nothing yet.
This situation strikes me as being shockingly similar to when I sold my stake in Chesapeke Energy (CHK) because I was disgusted with its CEO Aubrey K. McClendon's pay package. Kraft may end up improving its margins after all and be a very solid investment over the next several years, but I'll be watching this one from the sidelines.
No position in KFT